Abstract
Investment decisions may be evaluated via several different metrics/criteria, which are functions of a vector of value drivers. The economic significance and the reliability of a metric depend on its compatibility with the Net Present Value (NPV). Traditionally, a metric is said to be NPV-consistent if it is coherent with NPV in signaling value creation. This paper makes use of Sensitivity Analysis (SA) for measuring coherence between rates of return and NPV. In particular, it introduces a new, stronger definition of NPV-consistency that takes into account the influence of value drivers on the metric output. A metric is strongly NPV-consistent if it signals value creation and the ranking of the value drivers in terms of impact on the output is the same as that provided by the NPV. The degree of (in)coherence is calculated with Spearman (1904) correlation coefficient and Iman and Conover (1987) top-down coefficient. We focus on the class of AIRRs (Magni 2010, 2013) and show that the average Return On Investment (ROI) enjoys strong NPV-consistency under several (possibly all) methods of Sensitivity Analysis.
Highlights
In capital budgeting many different criteria are used for evaluating a project, measuring economic efficiency, and making decisions
The average Return On Investment (ROI) exists and is unique, it has the unambiguous nature of investment rate, independent of the value drivers, and decomposes the economic value created into economic efficiency and investment scale
We investigate the coherence of average ROI and Net Present Value (NPV) and give a new, more stringent, definition of NPV-consistency, according to which a metric is strongly NPV-consistent under a given sensitivity analysis (SA) technique if it is NPV-consistent in the traditional sense and, in addition, the ranking of the project’s value drivers is the same
Summary
In capital budgeting many different criteria are used for evaluating a project, measuring economic efficiency, and making decisions. The above definition and eq (4) are interesting because they show that the AIRR approach enables reframing the NPV in terms of product of a capital base C and an excess returnı − k This means that the economic value created is determined by two factors: The project scale (C) and the project’s economic efficiency, ̄ı − k. Depp, estimates the amount of sales, the initial price(s), the costs for labor, material, maintenance, energy, the growth rates, the tax rate, etc These variables are risk factors, known as value drivers, for they affect the FCFs. given the project COC, the project NPV is computed. The analysis of change in a model’s inputs and the impact on the model output is the
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